There are several ratios that investors may use to gauge a company’s profitability and performance. Some of these may focus on the company’s profitability only. However, some others also help investors measure the company’s performance and efficiency. Among those, one of the most prominent ratios is the Return on Capital Employed (ROCE).
What is Return on Capital Employed?
Return on Capital Employed is a profitability and performance ratio that allows investors to assess a company’s profitability. It does so by gauging its efficiency in managing its capital. While investors want to know how profitable a company is, it is also crucial to determine how much capital it has used. It allows investors to make better comparisons between companies of different sizes.
ROCE is one of the most favourite ratios for investors. It combines several elements related to a company’s profitability into one. Simply put, it is the ratio of a company’s earnings and its capital employed. Overall, ROCE provides investors with a reliable and better measure of corporate performance. It is also easy to calculate as the information needed to use the ROCE formula is available in the financial statements.
How to calculate Return on Capital Employed?
Investors can use the following ratio to calculate a company’s Return on Capital Employed.
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) / Capital Employed
The Earnings Before Interest and Tax is available in a company’s Income Statement. On the other hand, the capital employed is available in the company’s Balance Sheet. There are two ways to calculate capital employed.
Capital Employed = Total Assets – Current Liabilities
Similarly, they can also use the following formula.
Capital Employed = Total Equity + Non-Current Liabilities
Regardless of which method investors use, investors will get the same capital employed.
Example
A company, Blue Co., had Earnings Before Interest and Tax (EBIT) of $100,000 in the last accounting period. The company also has total assets of $1 million and current liabilities of $200,000. Therefore, Blue Co.’s capital employed is $800,000 ($1 million – $200,000). It allows Blue Co. to calculate its Return on Capital Employed as follows.
Return on Capital Employed = Earnings Before Interest and Tax (EBIT) / Capital Employed
Return on Capital Employed = $100,000 / $800,000
Return on Capital Employed = 0.125 or 12.5%
How does the Return on Capital Employed work?
Return on Capital Employed is a metric that allows investors to compare various companies. Usually, a higher ROCE means that the company has efficiently used its resources to generate profits. ROCE is also useful in comparing companies in capital-intensive industries, allowing investors to make better decisions.
Return on Capital Employed shows how much earnings a company makes for each dollar of capital employed. It considers the EBIT, which shows how much profits a company generates from its operations only. Similarly, by incorporating equity and long-term debt, ROCE allows investors to consider the long-term capital which a company employs.
Conclusion
Return on Capital Employed is one of the most preferred ratios for investors. It allows them to gauge a company’s profitability and efficiency in using its resources. In short, Return on Capital Employed is the ratio of a company’s EBIT and its capital employed. The higher a company’s ROCE is, the better it is for investors.
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